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August 2011

zombie American consumers

Stephen Roach points out one number that is enough to explain why this recovery has been so anemic:

The number is 0.2%. It is the average annualized growth of US consumer spending over the past 14 quarters – calculated in inflation-adjusted terms from the first quarter of 2008 to the second quarter of 2011. Never before in the post-World War II era have American consumers been so weak for so long. This one number encapsulates much of what is wrong today in the US – and in the global economy.

There are two distinct phases to this period of unprecedented US consumer weakness. From the first quarter of 2008 through the second period of 2009, consumer demand fell for six consecutive quarters at a 2.2% annual rate. Not surprisingly, the contraction was most acute during the depths of the Great Crisis, when consumption plunged at a 4.5% rate in the third and fourth quarters of 2008.

As the US economy bottomed out in mid-2009, consumers entered a second phase – a very subdued recovery. Annualized real consumption growth over the subsequent eight-quarter period from the third quarter of 2009 through the second quarter of 2011 averaged 2.1%. That is the most anemic consumer recovery on record – fully 1.5 percentage points slower than the 12-year pre-crisis trend of 3.6% that prevailed between 1996 and 2007.

I have been tracking these so-called benchmark revisions for about 40 years. This is, by far, one of the most significant I have ever seen. We all knew it was tough for the American consumer – but this revision portrays the crisis-induced cutbacks and subsequent anemic recovery in a much dimmer light.

The reasons behind this are not hard to fathom. By exploiting a record credit bubble to borrow against an unprecedented property bubble, American consumers spent well beyond their means for many years. When both bubbles burst, over-extended US households had no choice but to cut back and rebuild their damaged balance sheets by paying down outsize debt burdens and rebuilding depleted savings.

Yet, on both counts, balance-sheet repair has only just begun. While household-sector debt was pruned to 115% of disposable personal income in early 2011 from the peak of 130% hit in 2007, it remains well in excess of the 75% average of the 1970-2000 period. And, while the personal saving rate rose to 5% of disposable income in the first half of 2011 from the rock-bottom 1.2% low hit in mid-2005, this is far short of the nearly 8% norm that prevailed during the last 30 years of the twentieth century.


Toss out the old valuation metrics

These days it's hard to take your eyes off the volatile markets.  One metric that investment gurus use to argue whether the market is overvalued or undervalued is the P/E ratio.  There is a group of people who prefer to use Bob Shiller's 10-year PE to smooth out the noises of business cycles.  But none of these took into consideration of the demographic change the US is facing in coming decades when "baby boomers", born between 1946-1964, reach their retirement age, i.e., between 2011-2029.

Should we expect the same valuation as in previous decades?   The recent research from San Francisco Fed. offers us some insights:

To examine the historical relationship between demographic trends and stock prices, we consider a statistical model in which the equity price/earnings (P/E) ratio depends on a measure of age distribution (for another example, see Geanakoplos et al. 2004). We construct the P/E ratio based on the year-end level of the Standard & Poor’s 500 Index adjusted for inflation and average inflation-adjusted earnings over the past 12 months. We measure age distribution using the ratio of the middle-age cohort, age 40–49, to the old-age cohort, age 60–69. We call this the M/O ratio. 

Figure 1 displays the P/E and M/O ratios from 1954 to 2010. The two series appear to be highly correlated.


Figure 2 compares the actual and model-implied P/E ratios for the sample period ending in 2010. We calculate the path for the model-implied P/E during the sample period by feeding in actual M/O ratios. We call the long-run path of the P/E ratio predicted by the model the “potential P/E ratio” and designate it P/E*. Figure 2 shows that the P/E* (red dashed line) is highly correlated with actual P/E during the sample period. 


Jeremy Siegel on market opportunities

Jeremy Siegel, professor at UPenn and founder of WisdomTree, also a long-term bull on equity, offers his insight on the investment opportunities after the heavy selloff of last few weeks.

He had a short: TIPS;

He had a long: dividend-paying stocks, excl. financials.

Are we repeating the same mistakes as Japan?

Debt-deleveraging and its economic consequences.

The perspective from Japan – interview of Richard Koo of Nomura.

David Rosenberg shares his latest assessment of data points. He called another recession “virtual certainty”.

Treasury yields signal the US heading into long slump

An update on my previous post, QE3 is coming (source: CNBC):

The impact of a US debt downgrade

Friday’s downgrade by S&P of the US sovereign debt, from AAA to AA+, was an extraordinary event in modern finance.  As reported by WSJ, the is the first time the US government debt lost its AAA credit rating in more than 70 years.

What does this mean for the US and world economy?  Here is an insightful interview of Nouriel Roubini (aka Dr. Doom), Christina Romer (former Chairman of President’s Council of Economic Advisors), and Jim Bianco (president of Bianco Research).


US Treasurys are widely held as collateral by many financial institutions around the world.  The biggest risk is a sharp fall in value of US Treasurys may trigger another credit dry-up in the financial system.  This is perfectly summarized in the following paragraphs in the WSJ piece:

J.P. Morgan Chase & Co. analysts estimate some $4 trillion worth of Treasurys are pledged as collateral by borrowers such as banks and derivatives traders. If that collateral isn’t considered as high quality by lenders, the borrowers could be required to cough up more cash or securities to put the minds of lenders at ease.

That could force investors to sell off other assets to come up with the money. In a worst case scenario, credit markets could seize up, as they did during the Lehman Crisis.

Money market funds held by millions of Americans hold some $1.3 trillion in securities directly or indirectly exposed to Treasury and government agency securities, as well as short-term loans to financial institutions, known as repos, which are backed by Treasurys. Experts say that the downgrade won’t force money market funds to sell. But there are still risks.

If Treasurys tumble in value, funds will be forced to mark down their holdings, raising the potential for some to “break the buck” as the Reserve Primary fund did during the worst of the financial crisis.


Lastly, let’s hope China and Japan won’t sell: a key concern will be whether the appetite for U.S. debt might change among foreign investors, in particular China, the world’s largest foreign holder of U.S. Treasurys. In 1945, foreigners owned just 1% of U.S. Treasurys; today they own a record high 46%, according to research done by Bank of America Merrill Lynch.

In theory, China and the US are on the same boat: a fall in US Treasurys won’t do Chinese any good.  But that’s only theory on paper: people do all kinds of things when they panic.  Same thing applies to governments.   Personally, I think the chance is very slim for Chinese to dump US Treasurys.  But always be reminded “what could happen” – Re-watching this 2009 interview of Julian Robertson of Tiger Management will help you appreciate the worst scenario.